All across America children have returned to school. Soon, parents will receive the first set of report cards that will indicate if their children are meeting expectations, just hanging on or falling behind. As children have to come clean about their school performance, our investments should come clean about their return performance. But how do you know if your investment performance puts you at the head of the class or in the principal’s office?
The answer is to compare your investment performance against an appropriate benchmark. A benchmark, which is often called an index, is a composite of purchasable securities whose combined performance reflects the overall market performance of the asset class or investment sectors that the index represents. Indices are developed, structured and maintained by various investment research firms such as Standard & Poor’s (S&P), Frank Russell Co. and Morgan Stanley Capital International (MSCI) for the purpose of providing institutional investors with a vehicle to gauge the performance of money managers. These indices are valuable because they provide you with a widely accepted baseline against which to evaluate your personal investment decisions.
The most popular indices for the U.S. stock market are the Dow Jones Industrial Average (DJIA), the S&P 500 Index and NASDAQ. The DJIA, the godfather of all benchmarks, is composed of 30 large industrial companies. Conversely, the S&P 500 index is composed of 500 of the largest and most widely held industrial, transportation, financial and utility stocks. This index is considered by many to be a better index than the DJIA because of the diversity of securities that compose it. The NASDAQ is popular because of its exposure to large technology companies.
As you can see, each index has a different composition, so it is important that you look beyond the name of the index and make sure the composition of the index reflects your investment portfolio.
There are indices for every asset class and investment style. For example, for midcap stocks, the most commonly used index is the Russell Midcap Index, while for small-cap stocks the index of choice is the Russell 2000. The MSCI Europe, Australia and Far East (MSCI-EAFE) index is most frequently used to value returns on international stocks. Bond investment performance is often valued against the performance of the Lehman Brothers Government/Corporate Bond index. This index is composed of government and investment-grade corporate bonds with maturities of one to 10 years.
To develop a market-based index, one should select the appropriate indices and blend them together based on the percentage that each sector represents in your portfolio. This will provide you with a benchmark that is consistent with your investments. Still, the best index for you as an individual investor is not a market-based index. Rather, the best benchmark for you is an index that reflects the return that you need to achieve to obtain financial independence within your desired time frame. At Wealth Management Network, we call this index your Personal Rate of Return (PRR). The PRR is based upon the minimum return hurdle that your assets must clear annually for you to achieve your personal financial goals. As such, your PRR is based upon your investment time horizon, risk profile and annual savings commitment. Ask your financial advisor to develop a PRR for you today and begin to value your performance against this more personalized benchmark. Further, make sure that your investment portfolio is calibrated to achieve that PRR return level. In this way, you are controlling the risk in your portfolio and managing it toward a return level that is consistent with your needs.
Benchmarking is critical to insure that you and your advisory team are achieving your desired results. Would you comfortably sit back and allow your children, grandchildren, nieces or nephews to perform poorly in school? It is important that you hold your money to a performance standard too.
By David Hinson